Chapter 4 Solutions

Chapter 4
21. To find the FV of a lump sum with discrete compounding, we use:

FV = PV(1 + r)t
a.
b.
c.
FV = $1,800(1.10)3
FV = $1,800(1 + .10/2)6
FV = $1,800(1 + .10/12)36
= $2,395.80
= $2,412.17
= $2,426.73
To find the future value with continuous compounding, we use the equation:
FV = PVeRt
d.
FV = $1,800e.10(3)
e.
The future value increases when the compounding period is shorter because interest is earned
on previously accrued interest. The shorter the compounding period, the more frequently
interest is earned, and the greater the future value, assuming the same stated interest rate.
= $2,429.75
22. The total interest paid by First Simple Bank is the interest rate per period times the number of
periods. In other words, the interest by First Simple Bank paid over 10 years will be:
.07(10) = .7
First Complex Bank pays compound interest, so the interest paid by this bank will be the FV factor
of $1, or:
(1 + r)10
Setting the two equal, we get:
(.07)(10) = (1 + r)10 1
r = 1.71/10 1
r = .0545 or 5.45%
23. We need to find the annuity payment in retirement. Our retirement savings ends and the retirement
withdrawals begin, so the PV of the retirement withdrawals will be the FV of the retirement savings.
So, we find the FV of the stock account and the FV of the bond account and add the two FVs.
Stock account: FVA = $700[{[1 + (.11/12) ]360 1} / (.11/12)] = $1,963,163.82
Bond account: FVA = $300[{[1 + (.06/12) ]360 1} / (.06/12)] = $301,354.51
So, the total amount saved at retirement is:
$1,963,163.82 + 301,254.54 = $2,264,518.33
Solving for the withdrawal amount in retirement using the PVA equation gives us:
PVA = $2,264,518.33 = C[1 {1 / [1 + (.08/12)]300 }] / (.08/12)

C = $2,264,518.33 / 129.565
C = $17,477.92
26. This is a growing perpetuity. The present value of a growing perpetuity is:
PV = C / (r g)
PV = $210,000 / (.12 .03)
PV = $2,333,333.33
It is important to recognize that when dealing with annuities or perpetuities, the present value
equation calculates the present value one period before the first payment. In this case, since the first
payment is in three years, we have calculated the present value two years from now. To find the
value today, we simply discount this value as a lump sum. Doing so, we find the value of the cash
flow stream today is:
PV = FV / (1 + r)t
PV = $2,333,333.33 / (1 + .12)2
PV = $1,860,119.05
27. The dividend payments are made quarterly, so we must use the quarterly interest rate. The quarterly
interest rate is:
Quarterly rate = Stated rate / 4
Quarterly rate = .09 / 4
Quarterly rate = .0225
Using the present value equation for a perpetuity, we find the value today of the dividends paid must
be:
PV = C / r
PV = $3 / .0225
PV = $133.33
28. We can use the PVA annuity equation to answer this question. The annuity has 19 payments, not 18
payments. Since there is a payment made in Year 4, the annuity actually begins in Year 3. So, the
present value of the annuity is:
PVA = C({1 [1/(1 + r)]t } / r )
PVA = $6,000({1 [1/(1 + .08)]15 } / .08)
PVA = $51,356.87
This is the value of the annuity one period before the first payment, or Year 3. So, the value of the
cash flows today is:
PV = FV/(1 + r)t
PV = $51,356.87/(1 + .08)3
PV = $40,768.74
29. We need to find the present value of an annuity. Using the PVA equation, and the 12 percent interest
rate, we get:
PVA = C({1 [1/(1 + r)]t } / r )

PVA = $750({1 [1/(1 + .12)]15 } / .12)
PVA = $5,108.15
This is the value of the annuity in Year 5, one period before the first payment. Finding the value of
this amount today, we find:
PV = FV/(1 + r)t
PV = $5,108.15/(1 + .09)5
PV = $3,319.95
33. The company will accept the project if the present value of the increased cash flows is greater than
the cost. The cash flows are a growing perpetuity, so the present value is:
PV = C {[1/(r g)] [1/(r g)] [(1 + g)/(1 + r)]t }
PV = $26,000{[1/(.11 .06)] [1/(.11 .06)] [(1 + .06)/(1 + .11)]5 }
PV = $107,030.69
The company should accept the project since the cost less than the increased cash flows.
35. The relationship between the PVA and the interest rate is:
PVA falls as r increases, and PVA rises as r decreases
FVA rises as r increases, and FVA falls as r decreases
The present values of $7,000 per year for 15 years at the various interest rates given are:
PVA@10% = $7,000{[1 (1/1.10)12 ] / .10} = $47,695.84
PVA@5% = $7,000{[1 (1/1.05)12 ] / .05} = $62,042.76
PVA@15% = $7,000{[1 (1/1.15)12 ] / .15} = $37,944.33
36. Here, we are given the FVA, the interest rate, and the amount of the annuity. We need to solve for
the number of payments. Using the FVA equation:
FVA = $25,000 = $125[{[1 + (.10/12)]t 1 } / (.10/12)]
Solving for t, we get:
1.00833t = 1 + [($25,000)(.10/12) / $125]
t = ln 2.6667 / ln 1.00833
t = 118.19 payments
41. Here, we are finding the interest rate for an annuity cash flow. We are given the PVA, number of
periods, and the amount of the annuity. We need to solve for the interest rate. We should also note
that the PV of the annuity is not the amount borrowed since we are making a down payment on the
warehouse. The amount borrowed is:
Amount borrowed = 0.80($2,400,000)
Amount borrowed = $1,920,000
Using the PVA equation:

PVA = $1,920,000 = $13,500[{1 [1 / (1 + r)]360 }/ r]
Unfortunately, this equation cannot be solved to find the interest rate using algebra. To find the
interest rate, we need to solve this equation on a financial calculator, using a spreadsheet, or by trial
and error. If you use trial and error, remember that increasing the interest rate decreases the PVA,
and decreasing the interest rate increases the PVA. Using a spreadsheet, we find:
r = 0.630%
The APR is the monthly interest rate times the number of months in the year, so:
APR = 12(0.00630) = 0.0756 or 7.56%
And the EAR is:
EAR = (1 + .00756/12)12 1
EAR = 0.0782 or 7.82%
43. We want to find the value of the cash flows today, so we will find the PV of the annuity, and then
bring the lump sum PV back to today. The annuity has 24 payments, so the PV of the annuity is:
PVA = $2,500{[1 (1/1.08)24 ] / .08}
PVA = $26,321.90
Since this is an ordinary annuity equation, this is the PV one period before the first payment, so it is
the PV at t = 6. To find the value today, we find the PV of this lump sum. The value today is:
PV = $26,321.90 / 1.086
PV = $16,587.26
44. This question is asking for the present value of an annuity, but the interest rate changes during the
life of the annuity. We need to find the present value of the cash flows for the last eight years first.
The PV of these cash flows is:
PVA2 = $1,700 [{1 1 / [1 + (.09/12)]96 } / (.09/12)]
PVA2 = $116,039.35
Note that this is the PV of this annuity exactly seven years from today. Now, we can discount this
lump sum to today. The value of this cash flow today is:
PV = $116,039.35 / [1 + (.12/12)]84
PV = $50,304.85
Now, we need to find the PV of the annuity for the first seven years. The value of these cash flows
today is:
PVA1 = $1,700 [{1 1 / [1 + (.12/12)]84 } / (.12/12)]
PVA1 = $96,302.37
The value of the cash flows today is the sum of these two cash flows, so:
PV = $50,304.85 + 96,302.37
PV = $146,607.22
49. a.
If the payments are in the form of an ordinary annuity, the present value will be:
PVA = C({1 [1/(1 + r)]t } / r)
PVA = $8,000[{1 [1 / (1 + .09)]10 }/ .09]
PVA = $51,341.26
If the payments are an annuity due, the present value will be:
PVAdue = (1 + r) PVA
PVAdue = (1 + .09)$51,341.26
PVAdue = $55,961.98
b.
We can find the future value of the ordinary annuity as:

FVA = C{[(1 + r)t 1] / r}
FVA = $8,000{[(1 + .09)10 1] / .09}
FVA = $121,543.44
If the payments are an annuity due, the future value will be:
FVAdue = (1 + r) FVA
FVAdue = (1 + .09)$121,543.44
FVAdue = $132,482.35
c.
Assuming a positive interest rate, the present value of an annuity due will always be larger than
the present value of an ordinary annuity. Each cash flow in an annuity due is received one
period earlier, which means there is one period less to discount each cash flow. Assuming a
positive interest rate, the future value of an annuity due will always be higher than the future
value of an ordinary annuity. Since each cash flow is made one period sooner, each cash flow
receives one extra period of compounding.

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What is the difference between discrete and continuous compounding?

How does the compounding period affect future value?

Chapter 4

21. To find the FV of a lump sum with discrete compounding, we use:

PVA = $2,264,518.33 = C[1 {1 / [1 + (.08/12)]300 }] / (.08/12)

PVA = C({1 [1/(1 + r)]t } / r )

Using the PVA equation:

We can find the future value of the ordinary annuity as:

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